The Financial Crisis


Time has come to consider seriously the establishment a European Securities and Exchange Commission.

Following on the “Subprime” crisis, the recent speculative excesses uncovered at the Société Générale in Paris have added considerably to the fragility of financial markets compromising the effectiveness of policy measures aimed at avoiding that advanced economies fall into recession.

 If anything, the rate cuts of 1 ¼% by the US Federal Reserve within a period of ten days, on top of a USD140 billion economic stimulus package, has heightened the degree of nervousness of markets, giving credibility to the idea that the authorities are near desperate.

Some emblematic gurus, such as George Soros, consider this state of affairs to constitute the most serious financial crisis since the Second World War! Public opinion is in disarray and confidence in markets – the most crucial of all ingredients – and in the capacity of authorities to deal with the situation are rapidly evaporating.

In the face of this deteriorating environment, we are treated, particularly in Europe, to the usual set of political incantation advocating “responsibility” and “transparency”, calling for more “regulation” and improved “controls”, condemning “speculation” and “greed”, as well as being distracted by collateral - though extremely sensitive - issues such as “political interference” in a market economy, be it for protecting employment,  resisting politically undesirable consequences of hypothetical rescue operations or transgression of European competition rules. Attention to essential questions is also being diverted by resuscitating the stale debate over the functioning of the ECB; this is particularly counterproductive at a time when the Bank constitutes one of the few stable and credible anchors capable of playing an important role in the restoration of confidence.

The media play a crucial role, highlighting the controversial political debate and analysing ad nauseum the possible penal aspects which have the greatest eye and ear catching power. Attempts to understand and explain the underlying causes of the crisis are few and far between as Professor Duhamel correctly pointed out on the popular “Politiquement Show” on LCI on January 31.

There is little doubt that globalisation of the world economy and, in particular, of financial markets has contributed simultaneously to a period of exceptional economic growth and to the increased interdependence and consequently greater vulnerability of economic actors.

During this period of unprecedented economic expansion all the “moving parts” of its complex construction have not developed at the same speed. Economic integration of the European Union, the successful creation of the Euro, the development of a regulatory framework (Lamfalussy process and Financial Services Action Plan) for EU financial markets and a structured dialogue on accounting and regulatory matters between the USA and the EU constitute no doubt important milestones. They have not however held up with the pace of technical progress in instant communications or financial innovation that floods the markets with new products, the impact of which is not necessarily well understood at the time. Over reliance on sophisticated management tools, (developed and understood only by a handful of experts), sometimes conceptually flawed, and in some cases acting as a shield for improper, reckless or even fraudulent use, are the ingredients that lead with increased frequency to crisis. Their impact tends to expand as the interdependence of actors increases through the ever growing flows of capital that circulate at the speed of light through the worldwide networks.

Boards of Directors and senior managers of financial institutions often no longer understand the risks undertaken under their responsibility, and even if they do, they are unwittingly exposed to excesses of others when systemic disruptions occur. The freezing of the inter-bank market, consequence of the closure of the US Commercial Paper market which constituted the pillar for carrying inventories of “Subprime” mortgage obligations, is a prime example of such an occurrence. It was aided and abetted by the greed of financial intermediaries, the excessive reliance on ratings and a “rule based” regulatory system (in the USA) which facilitated the avoidance of prudential safeguards.

The “principle based” European regulatory system, aimed at making actors more responsible, proved in these circumstances of little value to avoid “contamination” of the “Subprime” phenomenon as the role played by European institutions was concentrated at the end of the value chain after the abuses of the rule based US system had already infected the sector.

In order to avoid a complete breakdown of the inter-bank market, monetary authorities on both sides of the Atlantic, were forced to intervene by supplying massive amounts of liquidity to cash starved banks.  Happening at a moment when fears of inflation were rearing once again their ugly head, put those responsible for monetary policy in a most uncomfortable position having to choose, as the saying goes, “between a rock and a hard place”. There should be little surprise as to the negative market reaction which quickly dismissed the temporary relief provided by the Central Banks all the more that the stance adopted by the two main Central Banks concerned, appeared to underscore a fundamental difference in the appreciation of priorities (economic stimulus in the USA – inflation control in Europe). 

It is within this context that the disclosure of the massive trading loss incurred by the Société Générale hit the market adding a significant destabilising effect to an already fragile environment.

It is not the specific amount of the loss that is the most important aspect. Indeed, €5 billion, though by no means insignificant, will still not lead to an overall loss for the institution for the year 2007 if there are no further undisclosed losses to contend with. However, there is an immediate disastrous political fallout, particularly in France, insofar that, all by itself, the reported loss, incurred by a single private institution, is equivalent to 1/3 of the fiscal package aimed by the French Government at “stimulating” the economy shortly after the presidential elections of 2007. This aspect needs careful husbanding in order to avoid that short term measures, driven by public opinion, do not throw away the baby with the bathwater.

On the other hand, there are several crucial questions that need urgently to be addressed:

 -                          How was it possible to by-pass internal controls? Including accounting, risk management and supervisory procedures.-                          Why were breaches of existing rules not detected by auditors and or regulators? Is their responsibility engaged?

-                          If it can happen at Société Générale, an institution enjoying the highest of reputations, how can one be sure that the financial system itself is sufficiently robust?

-                          How can one protect the market from systemic consequences of such occurrences? -                          Who, within the Eurozone assumes the responsibility for managing such crisis? Are there adequate procedures in place?

It is important to assess the potential cumulative effects that result from the superposition of the “Subprime” and Société Générale crisis and then attempt to draw the lessons for the future.

A central question to be addressed is: should - and can - the problems that have surfaced be addressed effectively by “more regulation”? While there is always room for “better rules”, it would appear that within the European Union the main difficulty is the implementation, supervision and enforcement of existing rules.

The problem stems from two complementary factors:

-                          On the one hand the crying lack of resources, both human and financial at the disposal of the Regulators. Unable to hire the necessary competent talent to deal with the fast moving financial innovation, Regulators are mostly unable to carry out the necessary audits to ensure compliance with existing rules. This situation leads to a sense of impunity on behalf of financial institutions reinforced by the fact that enforcement is devolved to an also overstretched national judiciary left to apply laws that were neither conceived nor meant to deal with the type of transgressions involved. Obtaining actual convictions is extremely unlikely in Europe as opposed to the situation prevailing in the United States.

-                          On the other hand, despite the progress achieved through the FSAP, the continuing fragmentation of the responsibility for financial supervision and enforcement at Member State level is fundamentally at odds with the increased cross-border nature of financial markets.

It should be quite obvious that in the European integrated economic and financial Single Market, operating procedures, ethical and governance rules, supervision (both internal and external) and enforcement should be governed by laws and regulations decided preferably at European level (or at a minimum at Eurozone level). This is the only sensible way of addressing the inevitable cross-border consequences of any serious financial crisis and of establishing clear lines of responsibility for dealing with them.

This is why, after years of “muddling” along with the ingenious and - at its inception - the “politically correct” Lamfalussy process”, it is now urgent to take the bull by the horns and create a European Union equivalent to the American Securities and Exchange Commission.

 The more than justified fears of the European citizens that authorities, taken individually at national level, are no longer able to control their home markets create an ideal opportunity to launch a new chapter in European financial integration, on the heels of the new Treaty. It will provide the necessary tools to defend coherently the Union’s economic and financial interests on the world scene. The urgency stems from the need to prevent a breakdown of the financial system and to deal effectively with future crisis. The evidence that there is no other workable solution should overcome the reticence of the dourest Euro sceptics.Combining the existing (inadequate) resources of each national regulatory authority would increase efficiency even if additional considerable means are also needed. Preservation of the experience and know-how accumulated over the years in the National Regulatory Agencies should be preserved by structuring the system along the lines of the ECB transforming the CESR into the governing council of the future European Agency. Like the ECB, the Agency should be fully independent. It should be endowed with far reaching investigative and injunction powers as well as a capacity for enforcement falling short of penal jurisdiction which should be entrusted to a specifically staffed section of the European Court of Justice. AAs part of the lengthy negotiation process, which the complex nature of the subject entails, thought should be given to whether additional legislation is necessary to protect the public from reckless behaviour by demanding that investment banking and trading activities of a single financial group be carried out in legally separate entities as is the case in the United States since the removal of the Glass Stiegel Act. Such confidence building measures should go a long way towards restoring trust and allow markets to perform effectively their indispensable function of financing economic activity.

The European Commission, backed by the leaders convened last week by Gordon Brown in London, should take the initiative of suggesting to the forthcoming spring economic summit the creation of a high level group on the model of the Lamfalussy Committee of which DGECFIN and DGMARKT should jointly ensure the secretariat. The mandate should be to draft a comprehensive report on the pros and cons of establishing a single European Regulator for financial markets as well as to make specific recommendations on its feasibility and implementation.

Such an initiative would unite all Member States around the objective of making a lasting contribution to financial stability and remove some of the frustrations of those excluded from the London meeting. Failure to seize this opportunity will only lead to shelving necessary measures until the next - and perhaps deeper crisis - from which it might prove far more difficult to recover putting into question the survival of the single currency if not of the Union itself.    Strong leadership is needed, buttressed by unflinching political will, in order to overcome petty national political interests and ensure that the investment made in European integration which has given its citizens both peace and prosperity for over 50 years is not squandered.  Let us hope that our political masters live up to this daunting challenge.